This section of FinAid discusses a loophole that gives students who
consolidate their loans before they enter repayment an
effective interest rate reduction of 0.5% to 0.625%. With the
switch from variable rate loans to fixed rate loans for new loans
first disbursed after July 1, 2006, this loophole has
been rendered ineffective for new borrowers. With new Stafford loans,
the same interest rate is in effect during the in-school, grace and
repayment periods.

When a student consolidates his or her loans, the weighted average of
the interest rates is rounded up to the nearest 1/8th of a percentage
point. A key consideration, however, is which interest rate is rounded
up. If the student consolidates his or her loans before entering into
repayment, the interest rate used is the in-school rate, which is
lower than the rate used during repayment.

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This loophole is clearly documented in the Federal Register, as excerpted
below, and has been confirmed by direct communication with the US
Department of Education. It is also mentioned in the "Dear Colleague"
letter "GEN-99-17" and Direct Loan Bulletin "DLB-99-37", both of which
incorrectly state that the benefit is available only to the Direct
Consolidation Loan Program. Lenders are required to certify
consolidated loans at the in-school rate if the application was
submitted before entering repayment (e.g., during the in-school, grace
or deferment periods), regardless of whether the loan is being
consolidated into the FDSLP or FFELP programs.

The current in-school and repayment variable rate formulas are pegged to the
91-day T-bill rate plus margins of 1.7% and 2.3%, respectively. This
yields a difference of 0.6%. Depending on the 91-day T-bill rate and
the effect of the rounding, this can lead to an additional difference
of -0.10% to 0.025%. Thus the total difference in interest rates for
consolidated loans ranges from 0.5% to 0.625%. For example, in the
2000-2001 school year the in-school rate was 7.59%, and the repayment
rate was 8.19%, a difference of 0.625% after rounding to the nearest
1/8th of a percent.

The savings over the lifetime of the loan can be substantial. The
following figures assume an in-school rate of 7.625% and a repayment
rate of 8.25% after rounding, and hence a difference of 0.625% in the
interest rates.
For a 10 year loan, this is equivalent to a savings of $39.62 per
$1,000 borrowed over the lifetime of the loan. For a 15-year loan the
savings increase to $64.84 per $1,000 borrowed. For a 20-year loan,
$93.17 per $1,000 borrowed. For a 25-year loan, $123.34 per $1,000
borrowed. For a 30-year loan, $156.16 per $1,000 borrowed. Thus this
will save students hundreds or even thousands of dollars over the
lifetime of their loans. For example, a student who has $16,000 in
loans and consolidates at the in-school rate for a 25-year term will
save $1,982.71 over the lifetime of the loan.

It is worth noting that consolidating a loan locks in the interest rate
for the lifetime of the loan. This is in contrast with unconsolidated
loans, which use a variable rate that changes each July 1.
Thus a student who intends to consolidate his or her loans should
preferentially consolidate before entering repayment, in order to lock
in the lower interest rate.

If a borrower's application is received before the student graduates
or drops below half-time, the borrower automatically receives their six month
grace period. (The US Department of Education has confirmed this for
the Direct Loan Consolidation Program. It probably also applies for
FFELP loans.) Nevertheless, we recommend that students who intend to
consolidate before their loans enter repayment do so no later than the third
or fourth month of their grace period, to ensure that the
certification occurs before they enter repayment.

Students at Direct Loan schools can consolidate while they are still
in school to lock in the lower in-school rate, in addition to during the grace
period. (This provision was repealed effective July 1, 2006.) Students with bank-based loans from the FFEL program, however,
can only lock in the lower in-school rate during the grace period,
since they cannot consolidate while they are still
in-school. (Students in the FFEL program who have at least one Direct
Loan, however, may obtain a Federal Direct Consolidation Loan, and use
it to lock in the lower in-school rate before graduation.) However, a
loophole discovered in 2005 allows students in the FFEL program to
request early repayment status
while they are still in school. This allows them to consolidate while
they are still in-school. If they ask for an in-school deferment after
receiving early repayment status, the loans will be consolidated at
the in-school rate. (This loophole was closed effective July 1,
2006 by the Higher Education Reconciliation Act of 2005.)

Treatment of Interest Rate Reductions

Another issue is how the weighted average of the interest rates is
affected by incentive programs such as interest rate reductions for
prompt payment. The Federal Register excerpt does not explicitly state
whether it is the "applicable rate" or the "actual rate" as defined in
the various statutes and regulations. The word "apply" suggests the
former, while the word "current" suggests the latter.

However, the law is quite clear in describing the interest rate with
respect to consolidation as an "applicable rate" and not an "actual
rate". For example, 682.202(a) says that "The applicable interest
rates for FFEL Program loans are given in paragraphs (a)(1) through
(a)(4) of this section." Section 682.202(a)(4) describes the interest
rates for consolidation loans, and in particular, 682.202(a)(4)(iv)
describes the formula for calculating the interest rate on
consolidation loans. In contrast, a description of actual interest
rates is described in Section 682.202(a)(5), and explicitly refers to
the rates in 682.202(a)(4) as applicable interest rates: "A lender
may charge a borrower an actual rate of interest that is less than the
applicable interest rate specified in paragraphs (a)(1)-(4) of this
section." Thus it is clear that the interest rate used in
computing the weighted average during repayment is the applicable
rate and not the actual rate, and so does not include any
of the lender's voluntary interest rate reductions. The lender
may, of course, choose to apply such prompt payment discounts and
interest rate reductions to the loan after consolidation, as per 682.202(a)(5).

Excerpt from Federal Register

The following text is excerpted from the Federal Register,
Volume 64, Number 210, dated November 1, 1999.

Comment: In response to the Secretary's request for comments on how
to make these proposed regulations easier to understand, a major
association representing credit unions suggested that for clarity, we
provide an example to clarify the regulatory requirement to use
weighted average interest rates for Consolidation loans.

Discussion: The weighted average interest rate used for
Consolidation loans in both the FFEL and Direct Loan programs should be
calculated based on the interest rates that apply to the loans being
consolidated at the time the loan holders complete the verification
certificates. In making the calculation, it is important to note that
an interest rate that is lower than the repayment period rate applies
to most subsidized and unsubsidized Stafford loans in the FFEL and
Direct Loan programs during the in-school, grace, and deferment
periods. This affects the calculation of the weighted average interest
rate. If, for example, a loan is in a grace period at the time the loan
holder completes the verification certificate, the lower grace period
interest rate would be used in the calculation of the weighted average
interest rate on the Consolidation loan. Conversely, if the borrower
applies for a Consolidation loan after entering repayment on a loan,
the higher repayment interest rate of the loan being consolidated would
be used in calculating the weighted average interest rate on the
Consolidation loan.

The weighted average interest rate is a single interest rate that
is calculated by using the borrower's loan balances and the current
annual interest rate for each of the borrower's loans.

For example: A borrower has two subsidized Federal Stafford Loans,
one for $10,000 and the other for $5,000, both with an interest rate of
8.25 percent. The borrower also has a $3,500 unsubsidized Federal
Stafford Loan with an interest rate of 7.46 percent and a $3,000
Federal Perkins Loan with a 5.0 percent interest rate. The borrower
consolidates these loans.

The following steps outline one way to calculate the weighted
average interest rate:

Multiply the balance of each loan being consolidated by the
interest rate that applies to that loan at the time the verification
certificate is completed.

Add the calculated interest amounts for all loans being
consolidated ($1,648.60).

Add the loan balances for all loans being consolidated
($21,500).

Divide the sum of the calculated interest amounts by the sum of
the loan balance amounts (7.66%).

Round the quotient (the answer to Step 4) to the nearest higher
one-eighth of one percent (7.75%).

Compare the result in Step 5 to the 8.25% maximum interest rate
and determine which is lower. The lower of the two rates is the
borrower's fixed interest rate for the Consolidation loan.

The weighted average interest rate for the borrower in this example
is 7.75%.

Change: None.

Acknowledgments

Thanks to Phil Schrag, Bob Sandlin, and Karen Epps for help
identifying and confirming this loophole.